Balancing Act

Balancing Act
Effective diversification through risk-balancing

By Scott Wolle, CFA CIO, Invesco Global Asset Allocation

The mean-variance approach of traditional asset allocation is largely predicated on fairly precise return estimates. However, this fails to fully account for the risks investors face. The Invesco Global Asset Allocation team advocates balancing risk as the guiding principle behind the asset mix in a portfolio. The ultimate goal of this approach: generating healthy total returns while defending against huge portfolio losses.

The current downturn in both the credit and equity markets has compromised both traditional and alternative assets because of their heavy exposure to equity risk. Yet, this is hardly the first instance of underperformance from traditional mean-variance-based asset allocation. Significant draw-downs have occurred repeatedly during bear markets and corrections, undermining the intended goal of asset allocation: to grow portfolios consistently over time.

The best strategic allocations are those that defend the portfolio in various or differing economic environments while still participating in economic growth. To do this, investors must not only be mindful of their asset selection, but also reconsider how they mix these assets when constructing their portfolios. The majority of investors have portfolios that are biased toward assets such as stocks that do well in periods of non-inflationary growth. Allocations to bonds, which are the best defense against recessionary periods, are often too short in duration and too credit risk-oriented. Historically, the best assets for a recession have been long duration, hedged government bonds. Additionally, investors are often under-exposed to assets that do well in inflation-driven markets. Direct real estate is an excellent example and commodities can play an important role as well.

If we use the simple example of a traditional balanced portfolio consisting of 60% equities and 40% fixed income, we might initially view this as a well-balanced portfolio--after all, the weights are nearly equal. However, the portfolio does not adequately consider the risk exposure to the asset classes. In a 60/40 portfolio, about 90% of the risk comes from stocks because they are so much riskier than bonds. This means that balanced portfolios often perform poorly in periods that don’t favour stocks—recession and inflationary growth.

One of the primary objectives of a risk-balanced investment strategy is to build a portfolio that performs well in different economic environments. Investors should expect that a risk-balanced portfolio capture most, but not all of the performance of a 60/40 portfolio in a non-inflationary growth environment, when equities typically perform well. The true benefit of the risk-balanced approach comes in recessionary environments where the strategy is designed to protect on the downside, preserving portfolio value. The strategy may also outperform a traditional 60/40 portfolio in inflationary growth environments due to the commodity exposure in the portfolio. The result is a strategy that is designed to provide downside protection while providing the opportunity for higher compounded returns over time.

Investors may consider risk-balanced products in various contexts within a portfolio. The high degree of diversification in a risk-balanced portfolio means that it can have a substantially higher Sharpe ratio than traditionally balanced portfolios and may be able to minimize excessive losses associated with equity-dominated portfolios, potentially without a loss in expected return. Standalone risk-balanced products would be well suited as an alternative to the traditional balanced account.

The views expressed above are based on current market conditions and are subject to change without notice; they are not intended to convey specific investment advice. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.


 




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